Porter Stansberry: Horse, meet water

From Porter Stansberry, Editor, Stansberry Digest:

Grant’s Interest Rate Observer‘s twice-yearly conferences are the most prestigious speaking invitations in finance, and are usually limited to the world’s most in-demand hedge-fund managers, like Boaz Weinstein (Saba Capital Management) and Howard Marks (Oaktree Capital Management).

There, in the ballroom of the Plaza Hotel, across the street from Central Park, I watched our own Bryan Beach present to a large number of the top investors in the world.

This was a tremendous honor for Bryan and an important “hat tip” to Stansberry Research, which has gradually become one of the few go-to sources for good, independent thinking on finance.

I’ve long had a gentleman’s agreement with Jim Grant

We both understand that I wouldn’t disclose the investment recommendations given at his conferences. After all, he charges a lot of money to attend these events, and one of the major benefits of attending is the high quality of the investment recommendations offered.

But… I figure that this agreement doesn’t cover the work of our own analysts. So I’d like to share with you what Bryan explained to the Grant’s audience. I’ll even give you what I believe is an extraordinary investment idea based on his work.

I hope you’ll do one thing for me in return: Tell someone you trust and respect about our work. Help us continue to build our network and subscriber base.

This relationship should be a virtuous circle. We do our best for you, day after day – always putting our subscribers’ interests ahead of our own. And you can help us in this mission by simply endorsing our work to someone you trust and respect. That’s how you can help us continue to improve the quality of our research and improve the services we offer.

Bryan and his research partner Mike DiBiase study the corporate-bond market…

Stansberry’s Credit Opportunities is an unusual financial research product. It covers corporate bonds – specifically, high-yield corporate bonds (aka “junk” bonds). Oddly, in my view, most individual investors ignore corporate bonds altogether, especially high-yield bonds. Although these financial instruments carry less risk than stocks, they’re widely perceived as being riskier.

There are two reasons why I believe most investors should never buy stocks at all…

Instead, they should focus entirely on high-yield bonds.

First, high-yield bonds have a good recovery rate, on average. If a stock goes bad and you hang on, it can go to zero. That happens with corporate bonds, too. But it’s rare. On average, the recovery rate on bonds is more than 40%. That means if you’re buying corporate bonds at a wide discount to par, you can find attractive risk-to-reward situations.

If you’re buying a bond for, say, $0.60 on the dollar, research might show you that the recovery rate on this bond is likely to be 50% or better, meaning you’re only risking about 10% on your capital. If the bond doesn’t default, you’ll receive big coupon payments (more than 10% annually) and earn a capital gain (67%) when the bond is refinanced or pays off at par.

The economics of these setups mean you can usually find opportunities that will pay you more than investing in stocks, while taking far less risk. To quantify that for you, our Stansberry’s Credit Opportunities recommendations have averaged better than 20% annually, with a win rate of around 80% so far. Those are far better results than any of our stock-picking newsletters (or stock indexes) could achieve in the same periods.

Here’s the second reason I believe most investors would be better off in bonds than in stocks…

The outcomes of bonds are binary. They either default or they don’t. And management doesn’t have any choice about whether to repay or not. A bond is a legal obligation: If the managers can’t repay, the company goes bankrupt, they lose their jobs, and it has to sell all of the company’s assets to repay as much as they can. In other words, there’s a gun to their heads.

With a stock investment, usually a lot of things have to go right for you to win. Stocks are generally expensive relative to earnings, meaning that for you to earn a good return, the business has to grow faster than the economy. That’s difficult. And the management team can (and usually does) screw over shareholders in one of many ways. The managers can make boneheaded acquisitions. They can constantly increase their pay and stock-option grants. They can decide to reduce or not to pay dividends, etc.

The binary outcome of a bond means it’s a lot easier to figure out what’s most likely to happen. Either the company has the money or it can get the money to repay bondholders… or it doesn’t. That’s the only question bond investors have to answer. The binary nature of this puzzle is much narrower in scope than the almost endless questions that equity investors face – and that’s better for individual investors.

To answer that binary question accurately, we built our own proprietary database…

We started with all 40,000 separate bond issues that trade in the U.S., and we narrowed the universe to between 4,000-6,000 issues that trade with enough volume to be accessible.

We run all of the data behind these issues through a computer system we built, and we issue each bond its own credit rating. Then we compare our ratings against those of the major credit-rating agencies, which most investors on Wall Street use. Most of the time, our ratings and Wall Street’s ratings match up. But…

In a small number of cases, they don’t.

We then study these anomalies carefully and recommend individual bonds where we believe the market has made a significant misjudgment. Outside of few hedge funds, like Saba Capital and Oaktree, we don’t believe anyone else in the world does research as thorough as ours. (Not surprisingly, both Saba and Oaktree were both invited to speak at the Grant’s conference.)

Doing all of this number crunching is time-consuming and expensive…

But it pays off. And not just for finding bond recommendations. By studying the bond market carefully, we sometimes find situations where stocks are being badly mispriced.

We call these situations – where the bond and stock markets disagree – “Golden Triangle” opportunities. They happen where stock investors have become worried about the financial future of a business… but bond investors haven’t.

What we see happen in these situations is that the stocks fall for 18-24 months and then begin to bounce back, usually returning to their pre-crisis highs. We studied hundreds of these situations from 2010-2014. While 6%-8% of these situations do end up badly (i.e. falling even more), most of them perform extremely well, with an average return for the strategy overall of more than 130% in two years.

Bryan told the Grant’s audience about one of these situations that we’re following now…

CenturyLink (CTL) is an old, “copper-cage” telecom firm that serves mostly rural customers. Last November, it merged with Level 3 Communications, a cutting-edge telecom firm that owns one of the world’s best fiberoptic networks, and whose network carries most of the world’s Internet traffic.

Most investors don’t yet realize that while CenturyLink bought Level 3, Level 3’s managers are now running the company. We don’t believe most equity investors have a good grasp on how the company is likely to perform going forward, because most stock investors are studying Bloomberg datasets that are based on CenturyLink’s results before the merger. But this simply isn’t the same company anymore.

Mostly because of its heavy debt load, equity investors badly misunderstand the stock. Shares have fallen from more than $30 to less than $15 in the last two years. Meanwhile, investors who hold that debt (i.e. the bondholders) aren’t worried at all. In fact, most of these bonds or at or above par, except for the ones that go out until the 2030s and 2040s.

Who will be right? The nervous stock investors, or the richer and wiser bond investors? We’re betting on the bondholders. So did we recommend buying the bonds?

No. We recommended buying the stock. Why? Because we believe it’s safe, and it’s paying a far higher yield than the bonds. The current yield on CenturyLink is more than 12%. And if this stock follows the pattern we’ve seen in similar situations, we expect it to trade back above $30 within 24 months.

Horse, meet water,

Porter

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